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What’s Behind the Recent Reversal in Stocks?

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NATHAN PETERSON: Hello and welcome to Schwab Market Snapshot for August 15. I’m Nathan Peterson, and I’ll be your host for this week’s segment.
 
Today I’m joined by Schwab’s chief investment strategist, Liz Ann Sonders, to get her insights on the current market environment. Liz Ann, welcome back.
 
LIZ ANN SONDERS: Hi, Nate. Thanks, everybody, for tuning in.
 
NATHAN: So, Liz Ann, last week we got a roughly 2% from peak-to-trough pullback in the S&P and a subsequent spike in volatility. What’s your take on this recent bout in volatility and how much do you think North Korea played a role in that?
 
LIZ ANN: So, I think, North Korea certainly was a catalyst. In fact, the big reversal day was last Thursday when we got the news about North Korea. But given what had been deterioration in market breadth, prior to that, I think we were setting up for some weakness in the market regardless of the news that we got.
 
Now, if you think about North Korea as a so-called "crisis event"—you look at past history of maybe similar crises events—as long as they don’t turn into protracted military conflicts or become protracted economic events, they tend to have a fairly short-lived impact on the market. However, there’s also a seasonal thing we need to be mindful of right now. Many viewers may not be familiar with an effect that comes into play in years ending in seven—of which this is one of, course.
 
If you go back all the way to 1900 and you use the Dow--which has a longer history than the S&P--for probably a variety of reasons, maybe some of which are mystical, years ending in seven have notoriously brought corrective phases. In fact—with the exception of 1927, which had a 9% pullback—every year has experienced at least a 10% pullback.1 Leaving this year aside, of course, because the year isn’t over. And the concentration of weakness tends to be in the August/November period of time. So it’s just another thing to be mindful of when we think about the possibility for heightened volatility over the next few months.
 
NATHAN: Something to keep an eye on—and this isn’t the first time we’ve seen one of these flare-ups in volatility. Is there anything that you see that would suggest that investor sentiment has changed this time?
 
LIZ ANN: You know, sentiment has been interesting recently, because it’s been a mixed bag, depending on what indicator you look at. If you look at retail investor sentiment—American Association of Individual Investors is one of the common proxies for that—and, actually, on that measure, bullishness has been fairly subdued. Bearishness did pick up in the last week or so, maybe no surprise. Yet on the other hand, Investors Intelligence, which measures the sentiment of newsletter writers--so they’re sort of a hybrid between retail investors and institutional investors—bullishness has been much stronger there.
 
And then there’s a measure that I keep an eye on, put out by Sentiment Trader. Which is, as they call it, their smart money/dumb money competence indexes, and they measure the comparison between the two. And with this weakness we’ve seen recently, the smart money actually has gotten more optimistic, and you tend to want to move the same direction as those. So I think sentiment has been mixed but nowhere near the kind of euphoria that you might expect, given that the market is near all-time highs, which is good news.
 
NATHAN: That makes sense. Can you speak some to our bias towards large-caps and whether that has shifted or changed, given the recent environment?
 
LIZ ANN: Yeah, when we started the video we talked a bit about market breadth broadly having deteriorated. But, interestingly, the deterioration has been much more significant for small-cap stocks. Not just in the past week or two, but really in the last few months. And since the election, small-caps—which have gotten a big boost relative to large-caps for the month after the election—all of those relative gains have been given back. And we’re now starting to see even more technical deterioration.
 
At the same time, the fundamentals are such that earnings growth expectations for large-caps are now higher than small-caps. Yet small-caps are still trading at a valuation premium, which begs the question: "Why would an investor want to pay a premium for a segment of the market that actually has a lower level of earnings growth?" So we do still believe in that large-cap emphasis as we look ahead to the remainder of this year.
 
NATHAN: Great. Well, that’s all the time we have for today. Liz Ann, thanks so much for your insights, as always. If you want to read more from Liz Ann you can do so in the Investing Insights section on Schwab.com, or you can follow her on Twitter @LizAnnSonders. We’ll be back next week. Invest wisely, own your tomorrow.
 
1Source: Bloomberg. *As of 08/11/2017.

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